Upload - Capital Budgeting Technique

CAPITAL BUDGETING TECHNIQUE

CAPITAL BUDGETING TECHNIQUE

Capital budgeting is the process of evaluating and selecting long-term

investments that are consistent with the firms goal of maximizing owners

wealth.

Capital expenditure is an outlay of funds by the firm that is expected to

produce benefits over a period of time greater than 1 year.

Operating expenditure is an outlay of funds by the firm resulting in benefits

received within 1 year.

The capital budgeting process :

1. Proposal generation.

Proposals for new investment projects are made at all levels within a

business organization and are reviewed by finance personnel.

2. Review and analysis.

Financial managers perform formal review and analysis to assess the

merits of investment proposals.

3. Decision making.

Firms typically delegate capital expenditure decision making on the basis of

dollar limits. Generally, the board of directors must authorize expenditures

beyond a certain amount. Often plant managers are given authority to

make decisions necessary to keep the production line moving.

4. Implementation.

Following approval, expenditures are made and projects implemented.

Expenditures for a large project often occur in phases.

5. Follow-up.

Results are monitored, and actual costs and benefits are compared with

those that were expected. Action may be required if actual outcomes differ

from projected ones.

TERMINOLOGY

Types of Project :

Independent Projects are those whose cash flows are unrelated to (or

independent of) one another; the acceptance of one project does not

eliminate the others from further consideration.

Mutually Exclusive Projects are those that have the same function and

therefore compete with one another. The acceptance of one BASIC

Teliminates from further consideration all other projects that serve a

similar function.

The availability of funds for capital expenditures

Unlimited Funds The financial situation in which a firm is able to accept all

independent projects that provide an acceptable return.

Capital Rationing The financial situation in which a firm has only a fixed

number of dollars available for capital expenditures, and numerous

projects compete for these dollars.

Basic approaches to capital budgeting decisions

AcceptReject Approach The evaluation of capital expenditure proposals

to determine whether they meet the firms minimum acceptance criterion.

(Mutually exclusive projects)

Ranking Approach The ranking of capital expenditure projects on the basis

of some predetermined measure, such as the rate of return.

CAPITAL BUDGETING TECHNIQUES

1. Payback Period (PP)

The amount of time required for the firm to recover its initial

investment in a project, as calculated from cash inflows.

The payback period can be found by dividing the initial investment by

the annual cash inflow. For a mixed stream of cash inflows, the yearly

cash inflows must be accumulated until the initial investment is

recovered.

1

Payback Period

2

Net Present Value

3

Profitability Index

4

Internal Rate of Return

Decision Criteria :

If the payback period is less than the maximum acceptable payback

period, accept the project.

If the payback period is greater than the maximum acceptable payback

period, reject the project.

(the maximum acceptable payback period is determined by

management)

2. Net Present Value (NPV)

Found by subtracting a projects initial investment (CF0) from the

present value of its cash inflows (CFt) discounted at a rate equal to the

firms cost of capital (r).

NPV = Present value of cash inflows - Initial investment

Decision Criteria :

If the NPV is greater than $0, accept the project. (Positive)

If the NPV is less than $0, reject the project. (Negative)

3. Profitability Index (PI)

Simply equal to the present value of cash inflows divided by the initial

cash outflow.

Decision Criteria :

If the index is greater than 1, accept the project.

If the index is less than 1, reject the project.

4. Internal Rate of Return (IRR)

The discount rate that equates the NPV of an investment opportunity

with $0 (because the present value of cash inflows equals the initial

investment). It is the rate of return that the firm will earn if it invests in

the project and receives the given cash inflows.

*before calculate, find out I2 > I1 and NPV must be negative.

Decision Criteria

If the IRR is greater than the cost of capital, accept the project.

If the IRR is less than the cost of capital, reject the project.

PROBLEMS

1. Fennicia Inc. is considering two mutually exclusive projects. Each requires

an initial investment of $100,000. The company has set a maximum

payback period of 4 years. The after tax cash inflows associated with each

project are:

Initial Investment $100,000 $100,000

Cash Inflows (CF)

Year

1 $10,000 $24,000

2 $20,000 $24,000

3 $30,000 $24,000

4 $40,000 $24,000

5 $20,000 $24,000

Determine the payback period of each projects. Which project should the

company invest in?

Project A

Year Cash Inflows Investment

Balance

0 ($100,000)

1 $10,000 -90,000

2 20,000 -70,000

3 30,000 -40,000

4 40,000 0

5 20,000

Payback Period of Project A is 4 years -> acceptable project

Project B

Year Cash Inflows Investment

Balance

0 ($100,000)

1 $24,000 -76,000

2 $24,000 -52,000

3 $24,000 -28,000

4 $24,000 -4000

5 $24,000

Payback period = 4 + = 4, 167 or 4 years 2 months ->

reject project

Based on the minimum payback acceptance criteria of 4 years set by

Fennica Inc, project A should be accepted. Company should invest in

Project A.

2. Aulia Dewi company can purchase a fixed asset for a $15,000 initial

investment. The asset generates an annual after tax cash inflows of $4,000

for 4 years.

a. Calculate the net present value (NPV) of the asset, assuming that the

company has a 10% cost of capital. Is the project acceptable?

b. Determine the maximum required rate of return that the firm can

have and still can have accept the asset.

Year Proceeds df : 10% PV

1 $5,000 0.909 $4,545

2 $5,000 0.826 $4,130

3 $5,000 0.751 $3,755

4 $5,000 0.683 $3,415

Total PV $15,845

Io $16,250

NPV ($405)

a. NPV < 1 -> Reject Project

b. $16,250 = $4,000 x (PVIFAk%,n)

PVIFAk%,4 = $16,250 $5,000 PVIFAk%,4 = 3,25 k = 9%

9% is the maximum required return that the firm could have for the

project to be acceptable. Since the firms required return is 10% the

cost of capital is greater than the expected return and the project is

rejected.

3. Heni manufacturing is attempting to choose the better of two mutually

exclusive projects for expanding the firm. The relevant cash flows for the

projects are shown in the following table.

Project X Project Y

Initial Investment $500,000 $335,000

Year

1 $100,000 $140,000

2 $120,000 $120,000

3 $150,000 $95,000

4 $190,000 $70,000

5 $250,000 $50,000

Calculate the IRR if the firms cost of capital is 15%. Which project, on the

basis, is preferred?

Project X

Initial Investment $500,000

Year df : 15% PV df : 16% PV

1 $100,000 0.870 $87,000 0.862 $86,200

2 $120,000 0.756 $90,720 0.743 $89,160

3 $150,000 0.658 $98,700 0.641 $96,150

4 $190,000 0.572 $108,680 0.552 $104,880

5 $250,000 0.497 $124,250 0.476 $119,000

Total PV $509,350 Total PV $495,390

Io $500,000 Io $500,000

NPV $9,350 NPV -$4,610

IRR > Cost of Capital or 15,67% > 15% -> acceptable project

Project Y

Initial Investment $335,000

Year df : 15% PV df : 16% PV

1 $140,000 0.870 $121,800 0.862 $120,680

2 $120,000 0.756 $90,720 0.743 $89,160

3 $95,000 0.658 $62,510 0.641 $60,895

4 $70,000 0.572 $40,040 0.552 $38,640

5 $50,000 0.497 $24,850 0.476 $23,800

Total PV $339,920 Total PV $333,175

Io $335,000 Io $335,000

NPV $4,920 NPV -$1,825

IRR > Cost of Capital or 15,73% > 15% -> acceptable project

Project Y, with the higher IRR, is preferred, although both are acceptable.

4. Using 14% cost of capital, calculate the net present value for each of the

independent projects shown in the following table, and indicate whether

each is acceptable.

Project A Project B Project C Project D Project E

Initial Investment (CFo)

$ 25,000

$ 550,000

$ 180,000

$ 1,000,000

$ 85,000

Year (t) Cash Inflows (CFt)

1 $

4,500 $

100,000 $

20,000 $

240,000 $ -

2 $

4,500 $

120,000 $

19,000 $

240,000 $ -

3 $

4,500 $

140,000 $

18,000 $

240,000 $ -

4 $

4,500 $

160,000 $

17,000 $

240,000 $

30,000

5 $

4,500 $

180,000 $

16,000 $

240,000 $

40,000

6 $

4,500 $

200,000 $

15,000 $

240,000 $ -

7 $

4,500 $

14,000 $

240,000 $

50,000

8 $

$ $ $

4,500 13,000 240,000 60,000

9 $

4,500 $

12,000 $

70,000

10 $

4,500 $

11,000

Project A :

NPV = {PMT x (PVIFA14%,10 yrs.)} Io

= {($4,500 x 5,216) - $25,000)

= $ (1,528)

NPV < 0 Reject Project

Project B :

Project B

CFt df 14% PV

$ 100,000 0.877 $ 87,700

$ 120,000 0.769 $ 92,280

$ 140,000 0.675 $ 94,500

$ 160,000 0.592 $ 94,720

$ 180,000 0.519 $ 93,420

$ 200,000 0.456 $ 91,200

PV $ 553,820

Io $ 550,000

NPV $ 3,820

NPV > 0 Accept Project

Project C

Project C

CFt df 14% PV

$ 20,000 0.877 $ 17,540

$ 19,000 0.769 $ 14,611

$ 18,000 0.675 $ 12,150

$ 17,000 0.592 $ 10,064

$ 16,000 0.519 $ 8,304

$ 15,000 0.456 $ 6,840

$ 14,000 0.4 $ 5,600

$ 13,000 0.351 $ 4,563

$ 12,000 0.308 $ 3,696

$ 11,000 0.27 $ 2,970

PV $ 86,338

Io $ 180,000

NPV $ (93,662)

NPV < 0 Reject Project

Project D

NPV = {PMT x (PVIFA14%,8 yrs.)} - Io

= ($240,000 x 4,369) - $1,000,000

= $ 113,360

NPV > 0 Accept Project

Project E

Project E

CFt df : 14% PV

$ - 0.877 0

$ - 0.769 0

$ - 0.675 0

$ 30,000 0.592 $ 17,760

$ 40,000 0.519 $ 20,760

$ - 0.456 0

$ 50,000 0.4 $ 20,000

$ 60,000 0.351 $ 21,060

$ 70,000 0.308 $ 21,560

PV $ 101,140

Io $ 85,000

NPV $ 16,140

5. Payback Period, Net Present Value, Profitability Index, Internal Rate of

Return - Independent Projects. Clarivtika Inc. has prepared the following

estimates for a long-term project it is considering. Using a 15% cost of

capital, Which of these projects would be acceptable under those cost of

capital under those cost circumstances? all projects is independent with

total budget $250,000.

Project A Project B Project C

Initial investment (Io) $85,000 $60,000 $130,000

Year Net Operating After Tax (NOPAT)

1 $45,000 $30,000 $30,000

2 $45,000 $40,000 $40,000

3 $45,000 $50,000 $50,000

Deprectiation using MACRS 3 years recovery year (33%, 45%, 15%, 7%)

a. Calculate payback period of each project

b. Calculate NPV of each project, using cost of capital of 14% and Rank

acceptable projects

c. Calculate Profitability Index of each project

d. Calculate the IRR of each project

e. Evaluate the accepability of each project using Payback periode, NPV,

IRR, and PI.

f. What recommendation would you make relative to implementation of

the project? Why?

*remember this exercise is independent projects

PROJECT A

Io $ 85,000

Year NOPAT Depretiation Cash Flow

1 $ 45,000 $ 28,050 $ 73,050

2 $ 45,000 $ 38,250 $ 83,250

3 $ 45,000 $ 12,750 $ 57,750

4 $ 5,950 $ 5,950

PROJECT B

Io $ 60,000


1 $ 30,000 $ 19,800 $ 49,800

2 $ 40,000 $ 27,000 $ 67,000

3 $ 50,000 $ 9,000 $ 59,000

4 $ 4,200 $ 4,200

PROJECT C

Io $ 130,000


1 $ 50,000 $ 42,900 $ 92,900

2 $ 50,000 $ 58,500 $ 108,500

3 $ 60,000 $ 19,500 $ 79,500

4 $ 9,100 $ 9,100

PROJECT Y

Year CF PVIF (14%,4)


0 ($60,000)

($60,000.00) 0 ($60,000)

($60,000)

1 $49,800 0.877 $43,674.60 1 $49,800 0.559 $27,821.23

2 $67,000 0.769 $51,523.00 2 $67,000 0.312 $20,910.71

3 $59,000 0.675 $39,825.00 3 $59,000 0.174 $10,287.10

4 $4,200 0.592 $2,486.40 4 $4,200 0.097 $409.11

Total PV $137,509.00

PV $59,428.14

NPV $77,509.00

Io ($60,000)

PI 1.15

NPV ($571.86)

PP 1.75

IRR 78.52%

PROJECT X



0 ($85,000)

($85,000.00) 0 ($85,000)

($85,000)

1 $73,050 0.877 $64,064.85 1 $73,050 0.588 $42,970.59

2 $83,250 0.769 $64,019.25 2 $83,250 0.346 $28,806.23

3 $57,750 0.675 $38,981.25 3 $57,750 0.204 $11,754.53

4 $5,950 0.592 $3,522.40 4 $5,950 0.12 $712.40

Total PV $170,587.75

PV $84,243.74

NPV $85,587.75

Io ($85,000))

PI 2.01

NPV ($756.26)

PP 1.14

IRR 69.51%

RANKING

Ranking Project Payback Period

1 Y 1.14

2 X 1.15

3 Z 1.34

Ranking Project NPV

1 Z $ 93,959.50

2 X $ 85,587.75

3 Y $ 77,509.00

Ranking Project IRR

1 Y 78.52%

2 X 69.51%

3 Z 54.15%

Ranking Project PI

1 Y 2.29

2 X 2.01

3 Z 1.72

Kesimpulan : karena project bersifat independen dengan budget $250,000

maka project yangdapat diterima adalah project Y dan project X dengan

total budget $180,000 ($60,000 +$130,000). Karena project X dan Y

menghasilkan IRR dan PI paling besar.

6. Payback Period, Net Present Value, Profitability Index, Internal Rate of

Return - Mutually Exclusive Projects. Mediyanti is considering two

mutually exclusive projects, each with an initial investment of $ 400,000.

The company has set a maximum 5-year payback requirement and has set

its cost of capital at 12%. The cash inflows associated with the two projects

are shown below.

Year Project X Project Y

1 $120,000 $118,000

2 $120,000 $120,000

3 $120,000 $122,000

4 $120,000 $124,000

5 $120,000 $126,000

a. Calculate each projects payback period

b. Calculate NPV of each project at 12%

c. Calculate PI of each project

d. Calculate the IRR of each project and use it to determine the highest

cost of capital at

which all of the projects would be acceptable

e. Rank the projects by each of the techniques used. Make and justify a

recommendation

a. Payback Period

Project X

Year 0

$ (400,000.00)

1 $120,000 $ (280,000.00)

2 $120,000 $ (160,000.00)

3 $120,000 $ (40,000.00)

4 $120,000 5 $120,000

Project Y

Year 0

$ (400,000.00)

1 $120,000 $ (280,000.00)

2 $124,000 $ (156,000.00)

3 $118,000 $ (38,000.00)

4 $126,000 5 $122,000

b. NPV

PROJECT X

Project X

Initial Investment $400,000 Year

df : 12% PV

1 $120,000 0.893 $107,160

2 $120,000 0.797 $95,640

3 $120,000 0.712 $85,440

4 $120,000 0.636 $76,320

5 $120,000 0.567 $68,040

Total PV $432,600

Io $400,000

NPV $32,600

PROJECT Y

Project Y


df : 12% PV

1 $120,000 0.893 $107,160

2 $124,000 0.797 $98,828

3 $118,000 0.712 $84,016

4 $126,000 0.636 $80,136

5 $122,000 0.567 $69,174

Total PV $439,314

Io $400,000

NPV $39,314

c. . Profitability Index

d. IRR

Project X


df : 16% PV

1 $120,000 0.862 $103,440

2 $120,000 0.743 $89,160

3 $120,000 0.641 $76,920

4 $120,000 0.552 $66,240

5 $120,000 0.476 $57,120

Total PV $392,880

Io $400,000

NPV -$7,120

Project Y


df : 16% PV

1 $120,000 0.862 $103,440

2 $124,000 0.743 $92,132

3 $118,000 0.641 $75,638

4 $126,000 0.552 $69,552

5 $122,000 0.476 $58,072

Total PV $398,834

Io $400,000

NPV -$1,166

e. Rank and Recommendation

RANKING PROJECT PP NPV PI IRR

1 X 3 tahun 10 bulan $32,600 1,0815 15,28%

2 Y 3 tahun 6 bulan $39,314 1,0983 15,88%

Dikarenakan project bersifat mutually exclusive maka Project Y sebagai

project yang diterima. Hal ini dikarenakan, Project Y memiliki PP yang

lebih kecil dan NPV, IRR, dan PI lebih besar daripada project X.

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